Hamish McRae: Stock markets may have hit the bottom but don't expect a bull run

Wednesday 16 October 2002 23:00 BST

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Was that it then? The hunt for the bottom continues, yet hardly anyone has the self-confidence to declare that the bounce of the past few days signifies the absolute bottom of this equity cycle.

Was that it then? The hunt for the bottom continues, yet hardly anyone has the self-confidence to declare that the bounce of the past few days signifies the absolute bottom of this equity cycle.

That lack of self-confidence is understandable. Even City professionals feel an element of shame at having their optimism proved so wrong. Still, a new line of thought has been becoming more and more evident and it is this. While this most recent bounce may be just that, a little tick up along the dreary path down, you hear increasingly two propositions:

One is that while it is perfectly plausible that the next low for shares may be a bit below the last one, we are not far from the bottom of this equity cycle. The other is that, by the same token, we are also not far from the top of this bond cycle.

To recap on the false bottoms: taking US data rather than UK, because the States will shape the rest of the world, there have now been four false bottoms (see left graph). If that bottom of 7,286 on the Dow, reached on 9 October, does not mark the turning point, that could be considered a fifth. (The best definition of a false bottom is one from which shares recover 10 per cent or more, but then is breached by yet another low.)

But a bottom of an index is not a bottom of an individual share. So it is perfectly plausible that the shares of several, maybe many, big companies have already passed their low point. I am grateful to Don Straszheim, the independent economist based in Santa Monica, for making this point. Bottoms in retrospect look clear turning points for the various indices, but if you look at individual shares, they hit bottom over a period of several months.

For what it is worth Dr Straszheim believes that while fundamental problems, such as the lack of profitability of US companies, are unresolved, one should be cautious about buying shares. But he also thinks this feels more like a bottom than a top in equities, and more like a top than a bottom in bonds.

You can see the relative performance since 1998 in US 10-year Treasuries and equities, as measured by the S&P 500, in the middle graph. If you held equities at the start of 1999 and then made the switch into bonds at any time between the middle of 1999 and the middle of 2000 you could have done extremely well. At some stage it will be right to make the switch back. But now?

Well, think what it felt like during the second half of 1999. The millennium was still to come, the dot.com fever was mounting by the month, and the market analysts were predicting that the US economy was set on a new higher growth path, which justified the rising share prices. Some of us wrote about the dangers of a post-millennial flop and that has proved right. But I am not sure we felt too confident about our judgement at the time.

Now, the mood is the reverse. Just as there were perfectly good rational reasons for supporting the share price euphoria then, there are perfectly good rational reasons for supporting the share price gloom now.

Next, look at the bond market. There are perfectly good reasons for believing that government bonds, now at the lowest yields (or of course highest prices) for 40 years, are still fairly priced, but that is largely because shares have performed so dreadfully. Two or three years ago they did not look particularly attractive against equities, when shares were performing well. But that was exactly the right time to make the switch. At the moment the real global yield (ie allowing for inflation) is only about 2 per cent, lower than at any time since the early 1980s, when real yields were distorted by soaring inflation.

Goldman Sachs tackled this "Is there a bond bubble?" question in a recent newsletter and concluded that the answer was no. There was not the excessive speculation normally associated with such bubbles. That is quite true: there is no great euphoria about getting into government bonds. But the fact remains that unless the world moves into a long period of falling prices, government bonds must be poorish value.

At least, it is said, governments have the taxing power to redeem their liabilities. But even that assumption must be somewhat suspect. Look at Japan, whose public sector finances are catastrophic. If deflation takes hold everywhere, as it already has in Japan, falling prices keep increasing the real burden of debt. For what it is worth (not a lot) my own hunch is that corporate bonds will come back into favour in the coming months, for the whole sector is currently bombed out. Once it is appreciated that there are bonds going cheap from large companies that are currently going through trading difficulties but are not going to go under, then that market will recover.

And equities themselves? The danger is that though they will recover we will have a long period when they bounce along near to the bottom, without any clear trend. That happened during the long flat period between 1962 and 1982. The Dow reached 995 in September 1966, but after just pushing through it a couple of times was still back at 784 in June 1982. It was a trading market, not a sit and hold one. If US shares really are as overvalued as many believe, then we could have another long flat period as profit performance gradually catches up with values. But it would be flat only on a long view, for there would lots of ups and downs on the way.

The huge problem for the US, of course, is the extent that borrowing has supported consumption. (Yes, I know we have that problem here too but it is not on the same scale.) You can see how US consumers have only started to rebuild their savings from the graph on the right. In a way, the boom in share prices (and also, though not shown) in house prices, has substituted for regular savings. You don't need to save if you feel rich. If US savings revert to the level of the early 1980s about 10 per cent of personal income would have to come out of consumption. Sure, that transition could take place over a decade, but you would still have to have wages rising perhaps half a percentage point a year faster than spending.

That suggests a world where consumption would rise at, say, 2 per cent a year in real terms, not the 4 per cent that companies in the United States have become accustomed to. Result: hard to push up profits. Further result: share prices will continue to disappoint over the next few years.

Enough of that. I still think that even if that was not the turning point, we are pretty close to it. Just don't expect a resumption of the strong bull market we got to know through the 1980s and 1990s for another few years at least.

The best historical example, at least as far as the UK is concerned, may be the long period between 1870 and 1890, when there was decent economic growth but also generally falling prices. Trouble is, there is no one alive to remember what that felt like for investors.